Magazine

The Dirty Little Secret About Buybacks

January 22, 2006

Reading Intel Corp.'s (INTC) latest annual report, you might think the chipmaker has returned huge sums of cash to its shareholders through stock buybacks. Since 1990, the report boasts, the company has repurchased from shareholders "2.2 billion shares at a cost of approximately $42 billion." That's a lot of stock -- about a third of Intel's total shares outstanding. There's just one problem: Intel had as many shares, split-adjusted, at the end of 2004 as it did in 1990.

Much of the cash, it turns out, went to sop up the hundreds of millions of shares Intel was simultaneously issuing for employee stock options. Joseph Osha, a semiconductor stock analyst at Merrill Lynch & Co. (MER), says perhaps half the cash devoted to stock buybacks in general serves as little more than "backdoor compensation" for employees.

Companies have been happy to keep this little accounting detail quiet as they devote record sums to buybacks. Howard Silverblatt, a stock market analyst at Standard & Poor's (MHP) (which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)), estimates that the companies in the S&P 500-stock index spent some $315 billion on their own shares last year -- nearly 2.5 times as much as in 2002. The high rate of buybacks will continue, Silverblatt predicts, because companies still hold troves of cash built up during the four-year economic expansion.

The logic of buybacks is sound. Companies with excess cash return some of it to shareholders by buying shares from them. Since there are fewer claims on the company, each shareholder's stake becomes proportionately larger. Plus, without buybacks, investors in some companies would see their stakes significantly diluted by options. "The point behind the stock buybacks is to return value to shareholders," says Intel spokesman Tom Beermann. "There is no other reason."

The problem, says Thomas M. Doerflinger, an equity strategist at UBS (UBS), is that you can't easily tell how much of what companies say they're spending actually gets to investors. In a recent report on what he calls "vanishing buybacks," Doerflinger found that the number of shares in the S&P 500 has continued to increase despite the bigger share-repurchase outlays by companies. In 2004, when companies reported spending some $197 billion on buybacks -- nearly 2% of the market value of the index -- the number of shares outstanding increased by 1.8%. In the 12 months through June 2005, shares increased 0.7%, and only a third of the companies actually shrank their share counts by at least 1%.

Consider Microsoft Corp. (MSFT). During its three fiscal years ending in June, 2005, the company reported spending $18 billion to buy back 674 million shares. At the same time it issued 666 million shares for $8 billion. In the end, Microsoft, which has some 10.6 billion shares outstanding, had reduced its total count by a negligible 8 million shares and had spent just $10 billion -- $6.6 billion after tax. Yet Microsoft execs present the gross sums they spend repurchasing stock as being on par with dividends they pay, including the huge $33 billion special dividend in December, 2004. "Many companies are very vocal about the money they spent buying back stock, but they're not very vocal about what percentage of that money goes to counteract options," says Merrill's Osha. Microsoft responded in a written statement that it regularly evaluates its buybacks and dividends to "best meet the interests of its diverse shareholder base."

To be sure, some companies, especially tech outfits, have been ramping up their buybacks enough lately to cut their share counts by more than their options raise them. During the 12 months through June 2005, 108 companies in the S&P 500 reduced their counts by 2% or more, up from 55 companies the year before. And 41 reduced shares outstanding by at least 5%, including Intel. Cisco Systems Inc. (CSCO) cut its count by 6%, and Dell Inc. (DELL) pared its outstanding shares by 4%. Dell Chief Financial Officer James M. Schneider says in the fiscal year ending in February the company will buy back four times as many shares as it grants in options. "The last couple of years we had all of this cash flow, and there's no real need to add cash to the [$12 billion] coffers," he says.

At first glance this seems unambiguously positive. Bill Miller, the portfolio manager of Legg Mason Value Trust (LMVTX) who has beaten the market for 15 years straight, says the move is good for Dell, which his fund didn't own as of its most recent disclosure. "Their stock is cheap, and they're putting their cash where it's worth more." He says tech outfits in general are moving in the right direction, from being the worst abusers of buybacks to becoming leaders in paring down their cash and share counts with buybacks. Buybacks will have more impact on share counts in the future because more companies, such as Microsoft, have scaled back options grants ahead of new rules requiring their cost be accounted for as an expense.

But reducing the share count can pose other problems in gauging a company's performance. That's because earnings per share, the most widely followed measure of profit growth, rises as share counts drop. The math is simple: The fewer the shares, the greater the earnings per share (EPS), assuming total profit, or net income, stays the same. Huge share-count reductions can juice EPS growth -- but some investors might not think to check both the net and per-share figures.

The discrepancy can be big. Dell and Cisco both cut their share counts sharply -- and as a result, their EPS grew much faster than than their net income. In their most recent quarters, based on the nonstandard accounting that the companies prefer, Dell's EPS grew 18%, while its net income grew 12%; Cisco's EPS grew 19%, while its net grew just 8%.

Which company's strong EPS growth rate is more likely to continue? Investors would have to dig through cash-flow statements and balance sheets to find out. There they would see that Dell has been funding its buybacks with cash it's making now. Cisco, on the other hand, has been tapping its savings as well. During the past 12 months, as Cisco spent $10 billion buying back stock and boosting earnings per share, it used as much as $4 billion of the $18 billion of cash and investments it had built up in past years. In other words, Cisco is using cash it generated long ago to boost its EPS today. "That's not the kind of growth you can count on to continue because it requires past resources," says Charles W. Mulford, an accounting professor at Georgia Institute of Technology.

THE CASE FOR DIVIDENDS

Cisco's vice-president for investor relations, Blair Christie, says investors understand the sources of the EPS growth. Officials have a limit in mind for how much of Cisco's cash they might use, but they haven't disclosed the amount.

The larger question is, why fiddle around with buybacks at all if the goal is to return cash to shareholders? Why not just issue dividends? "Dividends are a much, much more transparent and real way to return cash to shareholders," says UBS' Doerflinger. Tech executives say they prefer buybacks so they'll have the flexibility to adjust cash cushions in the event of industry downturns or investment opportunities. Once dividend payments are initiated, they're pretty much sacred. But Merrill Lynch's Osha says investors prefer dividends to buybacks because they want evidence that companies really will distribute profits to their investors. "Buybacks," he says, "don't represent the same long-term commitment to returning wealth to shareholders." If companies are afraid of commitment, investors might be, too.